Calculating earned income for self-employed individuals in 401(k) plans

Understanding earned income

Earned income for self-employed individuals is derived from their distributive share of profits and guaranteed payments for services. These amounts are typically reported on Form K-1 rather than Form W-2. Shareholders of S corporations may receive both K-1 and W-2 income.    

In 401(k) plans, earned income is used for:¹

• Allocations, accruals, and deductions
• IRC Section 401(a)(4) nondiscrimination testing
• IRC Section 415 annual additions limit
• IRC Section 401(a)(17) compensation limit

The circular relationship between earned income and plan contributions

The 401(k) income calculation for self-employed individuals is often described as circular. That’s because employer contributions depend on an individual’s earned income, and their earned income is reduced by the contributions. This circular relationship determines the final amount of earned income that’s used for tax filing and year-end nondiscrimination testing.

Earned income calculation process

The calculation differs for sole proprietors and partners, but the general framework is similar.

• Start with tax-based net earnings from self-employment
• Subtract specified tax deductions and plan-related amounts
• Resolve any circularity by determining employer contributions using a mathematical formula or estimated guesses

Let’s look at the specific calculations.  

Sole proprietors

• Start with the amount reported on Form 1040, Schedule C, Line 31 (net profit), before any reduction for retirement plan contributions
• Subject to the plan’s definition of compensation, subtract:   
      ○  Plan contributions allocated to common-law employees
      ○  50% of the self-employment tax deduction under IRC Section 164(f)
      ○  Employer contributions allocated to the sole proprietor
      ○ Elective deferrals, if the plan’s definition of compensation excludes them

The resulting amount, after resolving the circular effect of employer contributions, represents the sole proprietor’s earned income for 401(k) purposes.

Partners

• Start with the amount reported on Schedule K‑1 (Form 1065), Line 14(a) (net earnings from self-employment), before reduction for plan contributions
• Subject to the plan’s definition of compensation, subtract:
      ○  The partner’s share of plan contributions allocated to common-law employees
      ○  Deductions for Section 179 expenses
      ○  Unreimbursed partnership expenses and depletion on oil and gas properties
      ○  50% of the self-employment tax deduction under IRC Section 164(f)
      ○  Employer contributions allocated to the partner
      ○  Elective deferrals, if they're excluded from plan compensation under the plan document

The final amount, after accounting for these items and resolving circularity, is the partner’s earned income for plan purposes.

Collaborate for your plan’s success 

Understanding how earned income is calculated is an important step in making the most of a 401(k) plan as a business owner. Because the calculation method varies by business structure, coordination between your accountant and 401(k) plan service provider is critical. A collaborative approach can help keep your year-end compliance testing and employer tax returns on track.

FAQs

What counts as earned income for a self-employed 401(k)?

For self-employed individuals, earned income generally includes business profits and certain payments for services performed for the business. Depending on the entity type, these amounts may be reported on a Schedule C or K-1. Earned income serves as the basis for determining retirement plan contributions and applying various plan limits.

How do you calculate net earnings for retirement plan contributions?

Net earnings for retirement plan contributions typically start with business income and are adjusted for certain deductions. The calculation varies depending on the business structure and retirement plan design. Because multiple factors can affect the final amount, business owners often work with their accountant and plan service provider to ensure accuracy.

Can K-1 income be used for 401(k) contributions?

Yes, certain types of K-1 income may be used when determining 401(k) contributions for self-employed individuals. Eligibility depends on many factors, including the business entity and the nature of the income reported. Because not all K-1 amounts are treated the same way, business owners should work closely with their accountant and 401(k) service provider.

What deductions reduce self-employed retirement income?

Self-employed earned income is generally calculated after certain deductions are taken into account. These may include business expenses, one-half of self-employment taxes, self-employed retirement plan contributions, and other adjustments that reduce net earnings. Applying these deductions helps determine the amount of earned income available for retirement plan contributions and related plan calculations.